The GMO chief strategist highlights the factors behind the market's bullish bias, abnormally high corporate earnings, current valuation levels, a slowdown in productivity, and the great paradigm shift in natural resources.

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In Agriculture, It’s Good to Be Strong

Over the past three years, corn prices have doubled, soybeans have climbed more than 66%, and wheat has jumped 50% as challenging conditions in major growing areas in the United States, South America, and Russia have kept farmers from satiating growing consumption. Over the near to medium term, Morningstar’s agriculture analysts believe that normalizing weather and slowing demand will drive crop prices lower. But looking beyond the next five years raises important questions about farmers’ abilities to produce enough food to meet global demand. To find out what the outlook is for investors, we asked two analysts to discuss the challenges facing the agriculture-related companies they cover. Adam Fleck is an associate director of research, and Jeffrey Stafford is an equity analyst who covers agriculture and chemicals. We talked Dec. 13.

Philip Guziec: There’s been a lot of discussion about high food prices in the news. Can you get us up to speed? What’s going on there?

Adam Fleck: The food-price run-up in the U.S. is largely due to the terrible Midwestern drought, among the worst in several decades. Year-to-year changes in food prices are largely driven by weather. Demand growth—outside of corn-based ethanol, which is unique to the U.S.—is relatively steady in developed markets. So, as supply is either crimped or abundant, depending on growing conditions and how much was planted based on prices in the beginning of the year, we get situations like 2012, where reduced supply will lead to exorbitant price increases. But we can also get situations like 2009, when we saw reduced demand, partly because of the recession, but we also had a bumper crop that drove prices down.

Guziec: Why is the ethanol situation unique?

Fleck: In the early 2000s, we started to use corn for ethanol production. Before that, we didn’t use any of our crops in fuel production; today, anywhere from a third to 40% of our corn crop goes into ethanol. This has had the result of driving up demand, perhaps artificially, in the past eight to 10 years.

You know, corn is the not even the best biofuel out there. Sugar cane is much more efficient to use for energy. Nonetheless, we saw an abundant crop and a desire to become energy independent, so using corn to make ethanol seemed like a good idea at the time. However, it’s had the consequence of driving up corn prices. Before ethanol, corn would bounce around in the low-single-digit range, around $2 to $3 per bushel. Now, it’s at $7 to $8.

But here’s the interesting thing: We think that the growth rate of ethanol production is likely to slow, given that we’ve reached blending limits here in the U.S. So, we’re probably going to return to a situation where demand growth for corn, and other products such as soybeans and wheat, is more population-driven. There might be an increase from exports, but generally, we see demand slowing.

Guziec: What about the arguments that developing economies will increase the demand for food and put a strain on our food-supply system?